How to trade after huge up days

The S&P 500 surged about 5% on Wednesday and had another huge intraday move to the upside yesterday. What does it mean? Bullish investors see it as the start of a new move higher, and bearish commentators are out in full force to declare that this doesn’t happen in a healthy market. Who is right?

My interest was picked by this chart posted on Twitter:

We could say that 4.8% is a rather arbitrary value, but using a 4% or 5% threshold wouldn’t change much to this study. The author concludes that there is no predictive value in it, which is true in the sense that market has demonstrated nearly equal chances of being up or down 1 week, 1 month or 1 year after such a huge up day.

But the thing that picked my interest is the average 14.8% gain 1 year after a monster up day. That’s almost twice the historical average 8% annual gain for the S&P 500. Even if we leave out the 1930s (which dominate the results in that table) and consider the post WW2 examples, we see the tendency for strong 1 year gains holds up very well. Out of the 18 >4.8% up days since WW2 the market was up 16 times a year later. In fact it was up double digit % gains a stunning 14 times. You could have done a lot worse than buying after a 4.8% up day in S&P 500.

To understand why that is the case I took a look at the charts for those monster up days. Here is May 27, 1970:


Stocks climbed 5% on this day and it was the very first day of a 30 month bull market. A major buying opportunity.

October 1987:


Stocks climbed 5.3% on October 20 and it was the exact intraday low of the 1987 crash. A few more huge up days followed suit. Bull market continued for another 12 years, so it was a historic buying opportunity.

September 8, 1998:


Stocks climbed 5.1%. In this case the correction low was revisited a month after the huge up day, setting a double bottom, but then the bull market powered on. It was a good buying opportunity.

January 3, 2001:


Stocks climbed 5% on this day. This one came in the midst of an ongoing bear market and was clearly not a buying opportunity.

July 2002:


Stocks climbed 5.7% on the 24th, followed by another huge up day a week later. The market did retest the lows a few months later, setting a double bottom, and a 5 year bull market followed. Again the huge up day was a major long term buying opportunity.
Note how strong up days also followed right after the October 2002 and March 2003 lows. Those days saw gains of 3-4%, not making the 4.8% threshold used for this study, but still quite remarkable anyway.



The big bear market of 2008 gave us a string of huge up days. The market surged 5.3% on September 30, 2008. But in this case it only recovered about half of the previous day’s 8.8% loss, which would have made the surge more suspect. A series of huge up days followed from October to December. All were early, but would have been profitable buy signals for a >1 year hold.
On March 10, 2009 the market surged 6.4%, followed by another huge up day a few weeks later. This surge marked the start of a multi-year bull market. One of the best buying opportunities ever.

The law of small numbers applies. But it doesn’t look like huge up days are showing an unhealthy market, on the contrary. They most commonly appear in the late stages of a bear market and in the very early stages of a bull market advance. More often than not it’s a sign of health.
More than a few times those 5% surges have come just days after a major low. There are a few obvious reasons for such days. It’s probably a combination of bargain hunting and short covering that causes a buying panic as soon as selling dries up after a significant decline. The big surge traps shorts, who keep hoping for further declines. If that doesn’t happen those shorts become forced buyers that fuel the early stage bull market.

How to trade it? The logical conclusion is to buy on the heels of those huge up days. How do you know you are not buying the first of a series of huge up days in an ongoing bear market like 2008 or 1930? Well, you don’t. There is no way to tell. But a few things can help.
1) A really healthy big surge day usually closes above the highs of the previous day. If the surge breaks out to a multi-day high it is even better.
2) Use a stop loss somewhere below the most recent major low. It’s ok for the market to retest the lows. But a sustained close below the low set just before that huge up day puts major question marks behind the bullish thesis.
3) You want to see follow through. A proper surge day that marks the start of a major advance will be followed by other good up days. As bears are forced to close short positions it will create more +2% days. If the market fails to advance with closes above the high set on your big surge day then something is wrong.

Good luck.

By Dan

Author of LunaticTrader and Reversal Levels method. Stock market forecasts based on proprietary indicators, seasonal patterns and moon cycles.

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